News and opinions tailored to the interests of the community of early stage investors.

Thursday, June 27, 2013

Strangling Innovation: Tesla versus “Rent Seekers”, by Steve Blank

A guest post by Steve Blank

The greatest number of jobs is
created when startups create a new market – one where the product or service
never existed before or is radically more convenient. Yet this is where
startups will run into anti-innovation opponents they may not expect.
These opponents have their own name – “rent seekers” – the landlords of
the status-quo.

Smart startups prepare to face off
against rent seekers and map out creative strategies for doing so…. First,
however, they need to understand what a rent seeker is and how they operate…

———-

Recently, the New York and North
Carolina legislatures considered a new law written by Auto Dealer lobbyists that
would make it illegal for Tesla to sell cars directly to
consumers. This got me thinking about the legal obstacles that face
innovators with new business models.

While Tesla, Lyft, Uber, Airbnb, et al
are in very different industries, they have two things in common: 1) they’re
disruptive business models creating new markets and upsetting the status quo
and 2) the legal obstacles confronting them weren’t from direct competitors,
but from groups commonly referred to as “rent seekers.”

Rent SeekersRent seekers are individuals
or organizations that have succeeded with existing business models and look to
the government and regulators as their first line of defense against innovative
competition. They use government regulation and lawsuits to keep out new
entrants with more innovative business models. They use every argument from
public safety to lack of quality or loss of jobs to lobby against the new
entrants. Rent seekers spend money to increase their share of an existing
market instead of creating new products or markets. The key idea is that rent
seeking behavior creates nothing of value.

These barriers to new innovative
entrants are called economic rent. Examples of economic rent include
state automobile franchise laws, taxi medallion laws, limits on charter schools,
auto, steel or sugar tariffs, patent trolls, bribery of government officials,
corruption and regulatory capture. They’re all part of the same pattern – they
add no value to the economy and prevent innovation from reaching the consumer.

No regulation?Not all government regulation is
rent or rent seeking. Not all economic rents are bad. Patents for example,
provide protection for a limited time only, to allow businesses to recoup
R&D expenses as well as make a profit that would often not be possible if completely
free competition were allowed immediately upon a products’ release. But patent trolls emerged as rent seekers by using
patents as legalized extortion of companies.

How do Rent Seekers win?Instead of offering better products
or better service at lower prices, rent seekers hire lawyers and lobbyists to influence
politicians and regulators to pass laws, write regulations and collect taxes
that block competition. The process of getting the government to give out these
favors is rent-seeking.

Lobbyists also work through
regulatory bodies like FCC, SEC, FTC,
Public Utility, Taxi, or Insurance Commissions, School Boards, etc.
Although most regulatory bodies are initially set up to protect the public’s
health and safety, or to provide an equal playing field, over time the very people
they’re supposed to regulate capture the regulatory agencies. Rent Seekers
take advantage of regulatory capture to
protect their interests against the new innovators.

PayPal – Dodging BulletsPayPal consistently walked a fine
line with regulators. Early on the company shutdown their commercial banking
operation to avoid being labeled as a commercial bank and burdened by banks’ federal regulations.
PayPal worried that complying with state-by-state laws for money transmission would also be too
burdensome for a startup so they first tried to be classified as a chartered trust company to
provide a benign regulatory cover, but failed. As the company grew larger,
incumbent banks forced PayPal to register in each state. The banks lobbied regulators in Louisiana, New York, California, and
Idaho and soon they were issuing injunctions forcing PayPal to delay their IPO.
Ironically, once PayPal complied with state regulations by registering as a “money transmitter” on a state-by-state basis, it
created a barrier to entry for future new entrants.

U.S. Auto Makers – Death by Rent
SeekingThe U.S. auto industry is a textbook
case of rent seeking behavior. In 1981 unable to compete with the quality and
price of Japanese cars, the domestic car companies convinced the U.S.
government to restrict the import of “foreign” cars. The result?
Americans paid an extra $5 billion for cars.
Japan overcame these barriers by using their import quotas to ship high-end,
high-margin luxury cars, establishing manufacturing plants in the U.S. for
high-volume lower cost cars and by continuing to innovate. In contrast, U.S.
car manufacturers raised prices, pocketed the profits, bought off the unions
with unsustainable contracts, ran inefficient factories and stopped innovating.
The bill came due two decades later as the American auto industry spiraled into
bankruptcy and its market share plummeted from 75% in 1981 to 45% in 2012.

In these states it appears
innovation be damned if it gets in the way of a rent seeker with a good
lobbyist.

Much like Paypal, it’s likely that
after forcing Tesla to win these state-by-state battles, the auto dealers will
have found that they dealt themselves the losing hand.

Rent seeking is bad for the economyRent seeking strangles innovation in
its crib. When companies are protected from competition, they have little
incentive to cut costs or to pay attention to changing customer needs. The
resources invested in rent seeking are a form of economic waste and reduce the wealth
of the overall economy.

Startups, investors and the public
have done a poor job of calling out the politicians and regulators who use the
words “innovation means jobs” while supporting rent seekers.

What does this mean for startups?In an existing market it’s clear who
your competitors are. You compete for customers on performance, ease of use, or
price. However, for startups creating a new market – one where either the
product or service never existed before or the new option is radically more
convenient for customers - the idea that rent seekers even exist may come
as a shock. “Why would anyone not want a better x, y or z?” The answer is that
if your startup threatens their jobs or profits, it doesn’t matter how much
better life will be for consumers, students, etc. Well organized incumbents
will fight if they perceive a threat to the status quo.

As a result disrupting the status
quo in regulated market can be costly. On the other hand, being a private and
small startup means you have less to lose when you challenge the incumbents.

If you’re a startup with a disruptive business model here’s
what you need to do:

Map the order of battle

Laughing at the dinosaurs and saying, “They don’t get
it” may put you out of business. Expect that existing organizations will
defend their turf ferociously i.e. movie studios, telecom providers,
teachers unions, etc.

Understand who has political and regulator influence
and where they operate

Figure out an “under the radar” strategy which doesn’t
attract incumbents lawsuits, regulations or laws when you have limited
resources to fight back

AirBnb – Damn
the torpedoes full speed ahead
For example, Airbnb, thrives even though almost all of its “hosts” are not
paying local motel/hotel taxes nor paying tax on their income, and many hosts
are violating local zoning laws. Some investors and competitors may be
concerned about regulatory risk and liability. AirBNB’s attitude seems to
be “build the business until someone stops me, and change or comply with
regulations later.” This is the same approach that allowed Amazon to
ignore local sales taxes for the last two decades.

When you get customer scale and
raise a large financing round,
take the battle to the incumbents. Strategies at this stage include:

Use competition among governments to your advantage,
eg, if New York or North Carolina doesn’t want Tesla, put the store
in New Jersey, across the river from Manhattan, increasing New
Jersey’s tax revenue

No comments:

About Me

George McQuilken is a founding member of the eCoast Angels Network, a group of private investors backing early-stage companies.

McQuilken was founding CEO of four companies including RSA Security. As Editor of the IBM Systems Journal, he published many of the seminal papers on software management, measurement, security, and quality. He was a project leader at IBM’s Cambridge Scientific Center working on virtual machines and networking. He is a graduate of MIT and member of the IEEE and the ACM.